Steven C. Davis is a partner at Hartzog Conger Cason & Neville in Oklahoma City, and concentrates his practice in the areas of estate planning, post-death administration, and transactional tax.

Len B. Cason is a partner at Hartzog Conger Cason & Neville in Oklahoma City and a Fellow in both the American College of Tax Counsel and the American College of Trust and Estate Counsel. He authored "Maximizing Funding of Credit Shelter Trust with Non-IRA Assets" in the June 2002 issue of Estate Planning magazine, and "IRS Ruling Approves ‘Poorer Spouse Funding Technique' in the May 2004 issue of Estate Planning. Len also has written in these pages on the poorer spouse funding technique.

Jeff, Steve, and Len team up to tackle a most perplexing problem:

As the applicable exclusion amount increases (it will become $3.5 million for 2009, and potentially for the indefinite future), one of the hardest challenges in planning for a married couple is sheltering the unified credits of both spouses, regardless of the order of their deaths.

This objective is particularly difficult if the couple's aggregate wealth exceeds one applicable exclusion amount (meaning there will be taxes at the survivor's death under a plan that leaves everything to the survivor) but less than double the applicable exclusion amount (meaning that sheltering both credits is not so easy as simply dividing their wealth between the two spouses and waiting to see who dies first).

Keep reading and you'll learn more about the problem – and a most creative solution.

EXECUTIVE SUMMARY:

By a series of private letter rulings, the government has blessed an approach that entails creation of an inter vivos trust that gives the first spouse to die a Section 2041 general power to appoint sufficient assets of the trust to cause inclusion in the estate of the first to die and fully utilize that spouse's unified credit, followed by a life estate in the surviving spouse that the government concludes will not cause Section 2036 inclusion when the survivor dies, even though property in the trust originated with that surviving spouse.

Recently, Estate of Lee v. Commissioner gave planners pause about one conclusion in these rulings, that death of the first to die causes a taxable gift by the survivor that is offset by an available gift tax marital deduction — the issue being whether the testamentary lapse of a general power of appointment can generate a gift tax marital deduction, because the donee spouse already is dead.

Creative drafters seek to avoid this concern by triggering the general power taxation prior to the powerholder's death. But this can create control issues.

This discussion addresses those considerations.

FACTS:

Estate planning for spouses with disparate wealth often leads to the suggestion that the more wealthy spouse make a gift to the less wealthy spouse to cover the contingency of "deaths out of order." More often a planning concern in noncommunity property states, the tax-sheltering benefit of one unified credit may be lost if the non-propertied spouse dies first and no inter vivos intraspousal gifts were made.

Until the advent of the inter vivos QTIP trust, the only ways to address this concern were by:

outright lifetime gift to the less wealthy spouse,

an inter vivos general power of appointment marital deduction trust (which gave the donee spouse unfettered power to dispose of the transferred property), or

a Section 2513 inter vivos split gift to a third party (which took the property out of the marital coffers entirely).

Section 2523(f) now allows the propertied spouse to create an irrevocable inter vivos QTIP trust to pay income to the donee spouse for life, with the remainder passing as the donor spouse originally designated in the trust, or as the donee may appoint pursuant to a nongeneral testamentary power of appointment, if granted by the trust.

The donor spouse may make an inter vivos QTIP election under Section 2523(f)(4), making the initial transfer free of gift tax and, on the donee spouse's death, corpus will be includible in the donee spouse's gross estate, thus utilizing the shelter of that spouse's unified credit and taking advantage of the donee spouse's GST tax exemption — all without giving the donee spouse more control over the trust property than the donor chooses.

If control is not a concern, a different but equally effective alternative was originally addressed in Private Letter Rulings 200210051 and 200101021, in which spouses created joint settlor trusts, funded in the main with tenancy by the entirety or joint tenancy property.

While both spouses were alive, either could revoke the trusts unilaterally, in which case the property would be partitioned and delivered to the original owner (or, for concurrently owned assets, to them in equal shares). The first spouse to die was given a general power to appoint all of the trust property (in the 2002 Ruling it was an inter vivos power; in the 2001 Ruling it was testamentary, with no difference in the government's conclusions) and, in default of exercise, the property was allocated first to a credit shelter trust and any excess to the surviving spouse outright.

According to the government:

their initial contributions to the trust were not taxable gifts because of their retained powers to revoke;

any inter vivos distribution to either spouse constituted a gift of the distributed property by the non-recipient spouse to the recipient of the distribution, which qualified for the gift tax marital deduction;

when the first spouse died, all the trust property was includible in the estate of that decedent, half under Section 2038 due to the transfer with retained power of revocation and half under Section 2041 due to the general power of appointment;

when the first spouse died, the surviving spouse was deemed to make a gift of the survivor's share of the trust corpus, which also was deemed to qualify for the gift tax marital deduction; and

the credit shelter trust was treated as passing from the deceased spouse, meaning that the survivor would not suffer Section 2036(a)(1) retained interest inclusion of any part of that trust when the survivor dies.

It is item (4) in this summary that generates some angst.

A refinement (inspired by but not identical to Private Letter Rulings 200604028 and 200403094) will be attractive to many clients because it does not entail an irrevocable transfer to an inter vivos QTIP trust, nor a joint trust. Furthermore, any control granted to the first spouse to die is limited to a formula driven general power to appoint.

In this approach each spouse creates a separate revocable inter vivos trust, and each spouse's trust grants a general inter vivos power of appointment to the other spouse, exercisable at any time prior to the powerholder's death, over only those assets in the settlor's trust that would qualify for the gift tax marital deduction if transferred directly to the powerholder.

The amount subject to each power, determined by a formula, equals the excess of the powerholder's remaining applicable exclusion amount over the value of the powerholder's own taxable estate (determined without regard to the general power). The power is exercisable only by written notice from the powerholder to the trustee of the settlor's trust (usually this is the settlor, which raises the same cautions as are appropriate in any credit shelter trust situation with the surviving spouse as trustee, to preclude estate tax inclusion on the settlor's subsequent death).

The written notice-to-exercise requirement guarantees that the time of exercise precedes the powerholder's death, which addresses the most controversial issue with respect to this planning — whether a gift tax marital deduction is available to the settlor for the property subject to the power of appointment that is includible to the powerholder.

Without this element it might be argued that any gift occurred at the powerholder's death, when the power lapses and causes estate tax inclusion, and arguably a donor cannot make a marital deduction qualifying gift to a deceased spouse. That was the message in the discussion that recently spilled over to the planning discussed here. (In Estate of Lee, discussed by practitioners in LISI's LawThreads commentary "Does Recent Case Kill Poorer Spouse Technique?," the "surviving" spouse actually died 46 days before the taxpayer/decedent, and the Tax Court rejected the argument that a presumption of survivorship could salvage the section 2056 marital deduction.)

The inter vivos general power of appointment in the alternative discussed here cannot be revoked after the effective date of its exercise (a practical impossibility anyway), but the trust is revocable by the settlor and can be amended prior to the powerholder's death.

The trust document articulates the settlor's intent that a completed gift to the powerholder occurs on the effective date of exercise (immediately prior to the powerholder's death), which ought to qualify for the gift tax marital deduction because the powerholder is still alive at that time. Plus, assets that satisfy any exercise of the power are valued on the date when any exercise of the power becomes effective (again, immediately prior to the powerholder's death).

Immediately upon creation of the revocable trust the powerholder executes a Notice of Exercise with respect to the full amount subject to the general power, stating that the effective date of the exercise is immediately prior to the powerholder's death (as required by the power itself), but only if the settlor is then living. (A variation on this requirement would make the power itself conditional on the powerholder dying before the settlor.)

The power usually is exercised in favor of the powerholder's own revocable trust (typically created at the same time as the settlor's trust — although care is required to avoid potential application of the reciprocal trust doctrine).

This appointee trust contains traditional marital deduction and credit shelter formula language, with the expectation that exercise will fully soak up the powerholder's unified credit and fill up the powerholder's credit shelter trust, which will be held for the surviving spouse's overlife.

Although the powerholder could change that revocable trust without the donor-spouse's knowledge, the donor of the power can avoid most problems by remaining vigilant and altering the power granting trust if there are storm clouds over the marriage or if the powerholder changes the appointee trust in an unacceptable manner.

Thus far, most clients have not been unduly concerned with this risk. For those clients who are concerned, however, an alternative is to have the powerholder immediately release the general power, in lieu of the exercise just described. This precludes a result that many may fear, if the settlor spouse becomes incompetent or is simply unaware of the powerholder's activity.

The reason this immediate release of the general inter vivos power continues to accomplish inclusion in the powerholder's estate of the formula-determined amount that soaks up the powerholder's unused applicable exclusion amount is the second clause of Section 2041(a)(2):

The value of the gross estate shall include the value of all property . . . with respect to which the decedent has at any time . . . released [a general] power of appointment by a disposition which is of such nature that if it were a transfer of property owned by the decedent, such property would be includible in the decedent's gross estate under sections 2035 to 2038, inclusive.

In plain English, what this means is that the powerholder is treated as having made a lifetime withdrawal from the trust granting the general power and then made a contribution of that withdrawn amount back into that trust.

If the powerholder's ongoing enjoyment in or control over that trust would generate inclusion under any of the string provisions (for example, because the powerholder has a life income interest in that trust), then estate tax inclusion occurs at death notwithstanding the release. This inclusion is exactly what the spouses want, if the powerholder dies first, with unused unified credit.

This approach precludes misuse of the general power, because it precludes the powerholder from altering ultimate distribution of the property subject to the power. (Note that this denial may be undesirable if, for example, circumstances change after creation of the trust and the settlor is incompetent to alter the power granting trust.)

To avoid confusion, it is important to segregate those assets that were included in the powerholder's estate, during the overlife of the settlor of the power-granting trust. These included assets must pass into a trust for the overlife benefit of the surviving spouse and must be administered as would property in the powerholder's own credit shelter trust for the survivor's benefit.

This trust may provide the same enjoyment that any credit shelter trust would provide and still avoid inadvertent inclusion in the surviving spouse's estate on the second death. This is the key to the government's favorable rulings on this planning — by inclusion in the powerholder's estate and then exclusion from the original settlor's estate, the effect is to soak up and shelter the full unified credit of the first spouse to die.

Under the Notice of Exercise approach, this segregation occurs by the exercise itself.

Under the release of power approach it occurs under a default-of-exercise provision that applies by virtue of the powerholder's failure to exercise the power (that is, by virtue of the release) and sends the property subject to the power to a credit shelter trust created by the original settlor, essentially for the settlor's own benefit.

Either way, with inclusion to the powerholder and thus a "cleansing" of the wealth, the desired objectives continue to apply.

Segregation of the appointive property also makes it easier to identify any property includible in the powerholder's estate that is entitled to Section 1014 new basis — which raises an issue with respect to potential application of Section 1014(e) that is controversial and unresolved but not the primary object of the planning here under consideration (and thus not the subject of this discussion). If new basis is available, the parties obtain a bonus on the already very desirable objective of sheltering all the unified credit of the first spouse to die.

COMMENT:

The two approaches outlined here address what many regard as the weakest link in the analysis in the private letter rulings (the gift tax marital deduction), which is the issue upon which some commentators have focused in the wake of Estate of Lee (i.e., that it is illogical to treat a gift made to an already deceased donee as qualifying for the gift tax marital deduction). The Notice of Exercise or the release, either signed during the powerholder's lifetime, may eliminate those concerns while accomplishing the spouses' objectives.

The need to shelter both spouses' applicable exclusion amounts by using both of their unified credits, no matter which spouse dies first, will remain a significant planning objective unless Congress enacts portability of the unified credit (by which deceased spouses could leave to their surviving spouses the decedents' unused unified credits, which the survivors could use along with their own credits on the second death).

Until the government issues a long-pending revenue ruling on this particular planning, however, there will remain some risk that it may not succeed. And planning of this ilk will remain relevant even if Congress enacts portability, in cases in which portability is undesirable — such as a deceased spouse with intended remainder beneficiaries who the survivor is not likely to benefit.

In any event, it makes sense to hedge our bets on the most uncertain aspect of this credit sheltering approach.

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